Debunking the myths about the Basel III endgame regulation

Sophie Park/Bloomberg

The U.S. is the only major banking power that has yet to implement "Basel III endgame" standards. This regulatory regime seeks to increase capital requirements for large banks as well as smaller banks with significant trading activities. As federal regulators inch closer toward finalizing the endgame rules, bank CEOs and conservative legislators have been pulling out all the stops to browbeat regulators into adopting laxer standards. These opponents of the endgame proposal have deployed a number of arguments that must be debunked.

While the endgame proposal has many provisions, its most salient feature is that it requires banks to adopt a standardized framework to determine capital levels, in lieu of the proprietary risk models that have run the show thus far. Proponents of the status quo argue that internal models are fine-tuned to each bank's unique risk profile. However, such fine-tuning did little to avert the recent failures of Silicon Valley Bank and other banks in 2023 (even despite the regulatory interventions of the Dodd-Frank Act.) Similarly, the internal risk models devised by the legions of math and physics Ph.D.s. employed by banks did famously little to avert the 2008 financial crisis. Indeed, such failures are reminiscent of Long-Term Capital Management (LTCM), the hedge fund whose options bets almost caused a financial meltdown in 1998, despite the fund being led by Nobel Prize winners who literally wrote the book on options theory.

The Basel endgame eschews opaque and abstruse internal models in favor of a standardized approach that brings transparency and reliability to risk modeling. Aside from making it harder for banks to hide risk within proprietary spreadsheets, a standardized approach will also allow regulators (and banks themselves) to benefit from collective cross-industry data that can help avert crises before they happen.

Even though increased capital requirements could help avert or mitigate the next banking crisis, the endgame's opponents lament that it inefficiently requires banks to hoard idle cash derived from stock sales. However, this idea loses sight of the fact that even under the endgame proposal, banks can put their capitalized cash to work and earn revenue, while simultaneously improving their capital ratios. To achieve this, banks can sell off risky assets and instead purchase U.S. Treasuries, which carry a zero percent risk weight. Unlike illiquid investments, which are often zero-sum bargains with little benefit to anyone other than the concerned counterparties, Treasury purchases often fund massive government infrastructure projects that can boost the broader economy, if not save it, as we saw in 2020 with the government's COVID-related spending.

Bank lobbyists often argue that poor mortgage decisions, not exploding derivatives, caused the 2008 financial crisis. If that is true, then the endgame proposal will help avoid a similar crash in the future. Studies show that banks meeting higher capital requirements are more likely to make prudent lending decisions, since defaulting loans increase risk weighting. The endgame proposal's heightened capital requirements would force banks to reconsider their balance sheets and offload underperforming assets. This also means that banks would avoid underwriting the sort of overleveraged mortgages that contributed to the 2008 crash.

Regulation and compliance

Walls are closing in on the Basel capital reforms

In official comments on bank regulators' Basel III endgame capital proposal, concerns are being raised by a wide array of stakeholders — including civil rights advocates and consumer advocacy groups — suggesting major amendments or re-proposal may be necessary for the rule to cross the finish line.

By Ebrima Santos Sanneh

January 16

Some opponents of the Basel III endgame argue that it would not have averted the failure of Silicon Valley Bank. Experts actually disagree on whether Basel III would or wouldn't have saved SVB. But what is clear is that the endgame rules would push more banks to incorporate unrealized investment gains and losses (like the interest rate exposures that upended SVB) into their regulatory capital calculations. The incorporation of such real-time valuations would only improve resilience across the banking industry. Once SVB failed, its shareholder equity was insufficient to make depositors whole. The FDIC was essentially forced to compensate depositors even beyond the standard $250,000 level to quell anxious markets. It is incontrovertible that if SVB were better capitalized, more depositors would have been made whole through shareholder losses rather than the FDIC backstop. This would have been a preferable alternative, as the need for government intervention to safeguard SVB depositors is precisely what precipitated fears of a broader banking crisis in early 2023.

Another red herring is the claim that the Basel III endgame will cause marginalized communities to have less access to credit. The theory is that higher capital requirements will lead large banks to stop lending because it is too expensive. First, the numbers belie this claim: The endgame rules will increase banks' cost of funding the average lending portfolio by a measly 3 basis points (.03%). Secondly, these fears overstate the proportion of services that large banks currently provide to marginalized communities. Credit unions and community banks are not subject to Basel III, so even if large banks were pushed out of retail lending, these smaller entities would be available to pick up the slack. Large banks engage in a disproportionately small portion of mortgage, commercial real estate and small business lending as compared to credit unions and community banks. For example, the FDIC has found that the proportion of commercial real estate loans held by community banks has remained stable over the last 30 years even though the total share of banking industry assets held by these small banks has diminished significantly during the same period. Credit unions, in particular, do a better job than banks of catering to underserved communities. Large banks have a long history of withdrawing credit from these communities during tough times, whereas credit unions actually increase their lending during such periods. In light of these facts, bank CEOs' invocations of minority access to credit ring hollow.

Of course, not all lending business leaving big banks would flow to community banks or credit unions. Some of it would also flow toward the much-feared "shadow banking" industry. While unregulated banking is undoubtedly a concern, it should be noted that regulators already have shadow banking in their sights and Dodd-Frank included numerous provisions to regulate that industry. Moreover, there is no conclusive evidence that shadow banks pose more of a systemic risk than large banks. Indeed, some of the major shadow banking alternatives are actually well-capitalized fintech companies like Quicken Loans, which have not faced any more complaints or fines than the large banks impacted by the Basel III endgame.

Regulators must ensure that their proposal for capital requirement is not sidetracked by red herring arguments that could undermine the safety and soundness of the banking system.